What's a sector to do when it sees more than half a billion pounds slashed from its budget? This is the situation facing vice-chancellors since Lord Mandelson announced unexpectedly savage cuts to their funding just before Christmas. Heaping academic indignity upon incipient poverty, he also told them to change their degree structure wherever possible from the traditional three-year course to a cheaper, two-year version.

The extra financial strain comes just as the Browne review on student finance starts to take evidence on the quality of education offered by universities, and also its affordability for student and state.

Leaders in the higher education sector are fiercely defending their patch. Writing in the Guardian today, Wendy Piatt and Michael Arthur, director-general and chair of the Russell group, warn that the cuts could lead to "meltdown" in the sector. "It has taken more than 800 years to create one of the world's greatest education systems and it looks like it will take just six months to bring it to its knees," they say. "Cuts of this magnitude in overall funding will impact on the sustainability of our research and cannot fail to affect even the most outstanding universities."

And Steve Smith, president of Universities UK, believes that the cuts will mean hundreds of courses being closed, presumably as universities are forced to reduce student numbers and make swathes of staff redundant.

Chris Higgins, meanwhile, vice-chancellor of Durham University, a member of the 1994 group, says that in focusing on funding issues, the sector is engaging in the wrong debate. In a time of funding stringency, he says, it's more important than ever to take a step back to seriously consider the kind of HE sector the UK needs.

In an interview with Education Guardian, Higgins says that quibbling over the level of student fees and "futile arguments" as to whether a 2:1 from Cambridge is the same as a 2:1 from AN Other university risks shaping the sector's future, without any discussion of fundamental questions such as "what is the sector for and what kind of sector do we want?"

Higgins's own proposals are unlikely to make him friends across the board in higher education. If his views are shared by others in the sector, he's among the first to break cover with ideas that will be seen by many as elitist and divisive.

"The important thing to realise is that universities are not and should not all be the same," he begins. "We talk about a single sector, but actually we already have a differentiated sector with very different types of universities within it. This is something that is generally known, but is not talked about out of political correctness."

Does he mean that some just aren't as good as others? "It depends what you mean by good. We have, for example, around 20 or 30 research-led universities that really must focus on high-end, research-led teaching. We have another 100 or so that simply can't do that at the same level, but can and do do very different things very well. We have to understand that if around 40% of 18-year-olds in this country go to university, there's going to be a great deal of difference in the abilities, the needs and the motivations of those students. And so we need to think about how the sector should be differentiated to meet these different needs."

What Higgins has in mind is a small cohort of globally renowned, research-led universities with graduate schools and the authority to award PhDs. Then there might be a bigger group of universities that focus on what he calls their "economic and social environments", and where the teaching "is informed more by scholarship than research, and is perhaps more focused on vocational and professional HE". He cites Teesside University, near to Durham but offering a different style of education, as an example of excellence in this grouping.

A third grouping would be what he calls "local universities that are perhaps more like US community colleges, involved in widening participation and access".

Within these groupings, the universities that are the best at what they do would, he proposes, get a disproportionate slice of the available cake.

And because research-led teaching, he argues, is necessarily more expensive in terms of people and equipment required, those institutions like his own would get a bigger share. "There's a difference between research money and teaching money. Research money needs to go to the places that can get best value from it. And that is the top 20-30 universities where you have a real critical mass. In my view, those are the only universities where PhDs should be educated, because you need a critical mass of people from different disciplines to give the best and brightest people in this country the right education for them."

But what about the argument that undergraduates studying at universities outside Higgins's select few will not get good teaching if they have no access to academics who are excellent researchers? "No, that's not at all the case," he says. "You can teach different types of student very well in different ways without any research at all. There are a number of very good teaching-only universities that teach their students extremely well."

Higgins says there are two choices: spread the funding thinly, or allocate what he calls "different units of resource" to different "types" of university.

"If, for example, you're a local community university that can do two-year degrees, that's fine, but you need less money for a two-year degree."

And then, he observes, "there are some universities that are not doing anything very well. They should be allowed to close because that's not a good use of public money. Nor is it good for students to be going to a university that is failing to educate them in the way they deserve.

"We will lose the excellence of the sector if we reduce quality to the lowest common denominator. If we spread our resources too thinly, we will end up educating a lot of people poorly. And if we're going to carry on competing with the best in the world, we've got to cherish our world-class universities of different types and not pretend all our universities are the same."

His proposals elicit a savage response from others in the sector. Pam Tatlow, chief executive of the Million+ group, which counts 28 post-1992 universities as its members, says: "Chris Higgins poses some interesting questions based on the premise that students and universities and teaching and learning can be divided up along stratified lines – essentially a sheep and goats mentality," she says.

"It is based on the idea that there is an unspecified but small number of elite and exclusive institutions to be accessed by a few, but which deserve much greater funding – ironically to be provided from the public purse. That's how clubs work. Fortunately, British higher education has moved beyond the world of clubs and has a strong egalitarian tradition. There are good economic and social reasons for this."

And Ruth Farwell, chair of GuildHE and vice-chancellor of Bucks New University, says: "It would be a mistake to encourage the development of an HE sector riddled with even more snobbery than it already has by basing its future structure on an old-fashioned model resembling grammar schools and secondary moderns."